San Diego Law Review
Volume 29 | Issue 3 Article 3
8-1-1992
Corporate Benefits without Corporate Taxation:
Limited Liability Company and Limited
Partnership Solutions to the Choice of Entity
Dilemma
Richard L. Parker
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Recommended Citation
Richard L. Parker,Corporate Benefits without Corporate Taxation: Limited Liability Company and Limited Partnership Solutions to the Choice of Entity Dilemma, 29 San Diego L. Rev. 399 (1992).
Corporate Benefits Without Corporate
Taxation: Limited Liability Company
and Limited Partnership Solutions
to the Choice of Entity Dilemma
RICHARD L. PARKER*
Many businesses confront a common dilemma in selecting a proper entity for the conduct of their business-the desire to in-corporate for state law purposes, but to avoid the more onerous taxation imposed on corporate income. The options for dealing with this dilemma have changed significantly in recent years. One solution, the S corporation, has become less attractive. On the other hand, limited partnerships and limited liability companies may now permit new businesses to enjoy the best of both worlds-to have corporate benefits without corporate taxation.
TABLE OF CONTENTS
INTRODUCTION ... 401
1. HISTORICAL PERSPECTIVE ... 403
II. THE CHOICE OF ENTITY DILEMMA ... 406
A. The Goal of Pass-Through Taxation ... 406
1. The Benefits of Pass-Through Taxation ... 406
2. Exception for Income Splitting Situations ... 407
3. Public Trading Exception ... 410
4. Identity of Investors Exceptions ... 410
a. Tax-Exempt Investors ... 411
b. Nonresident Alien Investors ... 412
c. Potential Benefits of the Corporate Tax Regime ... 413
d. Other Differences ... 415
e. Summ ary ... 415
B. Preference for Incorporation for Business Purposes ... 415
1. Owner Liability ... 416
2. Organizational Continuity ... 417
3. Other Business Considerations ... 418
4. Summary ... 420
C. The Dilem ma ... ... 420
III. THE S CORPORATION SOLUTION TO THE DILEMMA ... 420
A. Limited Availability of the S Election ... 420
B. Tax Disadvantages of Subchapter S Versus Partnership Taxation .... 422
1. Inability to Adjust Inside Basis ... 422
2. Taxation of In-Kind Distributions ... 426
3. Inclusion of Debt in Outside Basis ... 427
4. Taxation of Contributions and Built-In Gain ... 428
C. Possible Benefits of Subchapter S over Partnership Taxation ... 429
1. Partnership Termination Versus Section 382 ... 429
2. Tax-Free Reorganizations ... 433
D. Summary ... 434
IV. THE ALTERNATIVE OF INCORPORATION WITH TAX REDUCTION PLANNING... 434
V. USE OF NONCORPORATE FORMS PRIOR TO 1988 ... 436
A. Entity Classification for Tax Purposes Prior to 1988 ... 437
1. Background ... 437
2. The Mechanical Test of the 1960 Regulations ... 439
3. Definition of the Corporate Attributes ... 440
a. Centralized Management ... 441
b. Continuity of Life ... 443
c. Limited Liability ... ... 446
d. Free Transferability ... 447
4. The Uncertain Role of Limited Liability ... 449
B. Imposition of Corporate Tax Under National Carbide ... 450
C. State Law Restraints on Use of Noncorporate Forms ... 452
VI. RECENT CHANGES AFFECTING THE CHOICE OF ENTITY ... 456
A. Liability of Limited Partners ... 456
B. Limited Liability Companies ... 459
C. Clarification of the Role of Limited Liability in Entity Characterization 462 D. Modification of the National Carbide Standards ... 464
VII. CHOICE OF UNINCORPORATED FORMS AFTER 1988 ... 465
A. Choice of the Limited Liability Company Form ... 465
1. In General ... 465
2. Ideal LLC Legislation ... 466
3. General Uses of the LLC Form ... 469
B. Use of the LLC to Obtain Corporate Benefits Without Corporate Taxa-tion ... 470
1. Centralized Management ... 470
2. Continuity of Life ... 475
3. Free Transferability ... 481
4. Summary ... 484
C. Choice of the Limited Partnerships Form ... 485
1. Suggested Use ... 485
2. Federal Tax Treatment of the Suggested Use ... 485
3. Corporate Equivalence of the Suggested Use ... 487
a. In General ... ... 487
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c. Complexity of Suggested Use ... 491
d. Summary ... 492
VIII. THE FUTURE OF CORPORATE INCOME TAXATION ... 492
CONCLUSION ... 496
INTRODUCTION
New businesses faced with the task of selecting the most appropri-ate form of business organization are often presented with a di-lemma. Corporations have served the needs of business very successfully for the past century and are generally the preferred form of organization for business purposes. However, the use of a corporate form subjects the income earned by the business to double taxation. Thus, the dilemma is whether to satisfy the business goals through incorporation' or reduce taxation through the use of a non-corporate form.2
There is a simple and obvious solution to this choice of entity di-lemma. Subchapter S of the Internal Revenue Code (Code) permits a business to incorporate and elect to have its income passed through to the shareholders in a fashion resembling the taxation of income earned through a partnership.3 Unfortunately, not all businesses can or should rely on subchapter S for several reasons. First, the right to make an S election is narrowly limited.4 Second, while taxation of
the income earned through an S corporation resembles the taxation of income earned through a partnership, it differs in ways that could cause a materially greater tax liability to be imposed on the share-holders of an S corporation than would be incurred by partners in like circumstances.5
Businesses unable to resolve the choice of entity dilemma by means of the subchapter S election have two alternatives: either they incorporate and take steps to ameliorate the more onerous tax bur-den imposed on corporate income or they organize as a partnership and endeavor to address state law issues as best they can without incorporation.
The incorporation alternative has probably been the most common solution for taxpayers not able to resort to the S election, and much time and attention has been devoted to developing techniques for re-ducing the tax burden. This approach is, at best, an accommodation
1. See infra text accompanying notes 25-72.
2. See infra text accompanying notes 73-98. 3. I.R.C. §§ 1361-78 (1986).
4. I.R.C. §§ 1361(a), (b) (1986). See also infra text accompanying notes 99-103.
to the competing concerns.6
The use of a noncorporate form to avoid double taxation while endeavoring to otherwise adequately address state law issues has been more problematic. The difficulty in using noncorporate forms has two sources. First, there has been reason to question whether a truly corporate-like relationship could be created in a noncorporate form of organization. In particular, concerns have existed as to whether owners who were active in the management and control of the business could shield themselves from personal liability.7 Second, even if taxpayers could find a means to create corporate-like rela-tionships without incorporation, it is incumbent on them not to be too successful in this effort. The Code imposes corporate income tax-ation not only on corportax-ations, but also on any other unincorporated associations in which the relationships too closely resemble those typ-ically present in a corporation.8
The ability to use noncorporate forms to achieve corporate-like re-lationships without also incurring corporate taxation has changed dramatically in recent years. The ability under state law to create noncorporate relationships closely resembling those typical of the corporate form has been greatly enhanced by a significant legislative trend in the states to limit the potential for owner liability. In addi-tion, in 1988 the Treasury finally completed a long period of study regarding the tax rules for entity characterization and announced its conclusion that these rules should not be modified. In particular, the Treasury also confirmed that arrangements providing owners with limited liability would not, for that reason alone, be subject to corpo-rate income taxation.10 This conclusion was immediately reflected in
Revenue Ruling 88-76,11 which held that a Wyoming "limited
liabil-ity company" would be treated as a partnership for federal income tax purposes notwithstanding the fact that the owners were statuto-rily protected from personal liability.2
This Article examines some of the history of business organiza-tions and the changes affecting choice of entity summarized above. It concludes that the recent changes affecting noncorporate forms have created significant new opportunities to fully solve the choice of
6. See infra text accompanying notes 168-74. 7. See infra text accompanying notes 264-78.
8. See I.R.C. §§ 7701(a)(2), (3) (1986). See also infra text accompanying notes
176-263.
9. See infra text accompanying notes 279-94.
10. I.R.S. ANN. 88-118, 1988-38 I.R.B. 25. See also infra text accompanying notes 295-306.
11. Rev. Rul. 88-76, 1988-2 C.B. 360. Limited liability companies are hereafter referred to as "LLCs."
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entity dilemma. Either a limited liability company or a limited part-nership with a corporate general partner can now be utilized to pro-vide owners with all of the principal benefits of incorporation without subjecting the income of the business to corporate income taxation.1 3 Given that corporate-like relationships can now be established for all practical purposes without subjecting businesses to corporate in-come taxation, this Article further concludes that corporate inin-come taxation must now be viewed as an entirely voluntary and elective regime for all new nonpublic businesses. In light of this conclusion, the interests of certainty, uniformity, fairness, and efficiency demand that Congress act quickly either to make the election expressly avail-able under the Code or to impose a business tax in a nonelective fashion.14
I. HISTORICAL PERSPECTIVE
The corporate form emerged during the nineteenth century in or-der to meet the changing needs of business after economic activity had shifted from small proprietorships, guilds, and agriculture into that of the industrialized era.15 The need of business enterprises to organize efficiently and retain capital and labor created significant pressures to develop a form of business organization that would per-mit investors to provide capital without risking their entire personal wealth, that vested management in representatives knowledgeable about the business, that assured that the capital, once organized, would continue to be productive notwithstanding changes in owner-ship, and that allowed investors the opportunity to realize the benefit of their investment without causing dissolution and liquidation of the organization.
13. See infra text accompanying notes 312-98. 14. See infra text accompanying notes 399-401.
15. For a brief history of the emergence of general corporation laws in the
The corporate form was not the only entity competing to meet the needs of business. The historical roots of the modern corporation lay in the franchises and monopolies available only through special char-ter from the sovereign authority,"6 and the need to obtain this special charter continued into the nineteenth century. Thus, businesses en-deavored to establish the needed relationships not only by seeking corporate charters from the sovereign, but also by endeavoring to adapt trusts, partnerships, and other forms to the same ends.17
Early on it could not have been certain that the corporate form would emerge as the common form of business organization. How-ever, over time the ability to obtain a special charter in the United States from the various state legislatures came to be fairly routine. This process finally led by the mid- to late-nineteenth century to rec-ognition of the need to eliminate the requirement of obtaining the consent of the state to incorporate, lest the state legislatures be over-whelmed. The devised solution was to replace the special charter sys-tem with general corporation laws under which a charter would be automatically granted to any person satisfying the statutory requirements.
Once general corporation laws had become widely adopted and well understood, it is hard to discern why a business permitted to incorporate would have chosen any other form of organization. Ab-sent tax considerations, it remains difficult today to posit a situation in which a person permitted to incorporate would be led to choose any other form of organization. Indeed, absent tax considerations, other business forms may well have developed into highly specialized vehicles, if not mere footnotes of legal history.
As interesting as it may be to speculate about life without income taxation, the reality is that income tax considerations loom very large. The twentieth century expansion of income taxation is perhaps as significant to business as the nineteenth century's acceptance of the corporation. Since 1909, the use of the corporate form has en-tailed an additional income tax burden that is not necessarily im-posed on other forms of organization.'8 As a result, taxpayers
16. See generally WILLIAM F. WALSH, A HISTORY OF ANGLO-AMERICAN LAW
377-80 (2d ed. 1932).
17. Alternatives that competed with the corporate form in an effort to meet the needs of business included joint stock companies, business trusts, limited partnerships, and partnership associations. For an early twentieth century overview of the alternatives to incorporation, see generally EDWARD H. WARREN, CORPORATE ADVANTAGES WITH-OUT INCORPORATION (1929).
18. A corporate income tax has been imposed on corporations continuously since the adoption of the Payne-Aldrich Tariff Act of 1909. See generally BORIS I. BITTKER &
JAMES S. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS
S 1.01 (5th ed. 1987). See also generally EDWIN R.A. SELIGMAN, THE INCOME TAX: A
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desiring to avoid more onerous taxation have continued to seek alter-native means of relieving those very pressures that led to the adop-tion of general corporaadop-tion laws, but to do so in a fashion that does not give rise to the corporate taxation.
Most of the alternative forms of organization that had competed with the corporate form did not long survive the renewed effort to create a hospitable form of business organization for the simple rea-son that those alternative forms so closely resembled corporations that corporate income taxation was imposed.19
The partnership has survived as the principal alternative to incor-poration for the simple reason that it is the only alternative form of business organization recognized under the Code.20 As a result, the partnership form has come to be utilized in surprising situations that would astound a nineteenth century lawyer.21 Indeed, in the early
adoption of the Sixteenth Amendment).
19. Joint stock companies have been expressly included within the definition of a corporation for income tax purposes since 1909. See Corporation Tax Law of 1909, 36 Stat. 112 (1909). Similarly, it was probably the partnership association that originally prompted the inclusion of "associations" in the definition of a corporation. But cf. Eliot v. Freeman, 220 U.S. 178, 187 (1911) (holding that the corporate tax was intended to apply to organizations created by statute or which "derive from that source some quality, or benefit not existing at the common law"). However, the use of so-called business trusts successfully avoided corporate taxation in the early part of this century. Id. See also Crocker v. Malley, 249 U.S. 223 (1919). The success was short lived and corporate taxa-tion was extended to such business trusts in 1924. See Hecht v. Malley, 265 U.S. 144 (1924) (applying corporate income tax to the same trust which had escaped taxation in
Crocker). See also Burk-Waggoner Oil Ass'n v. Hopkins, 269 U.S. 110 (1925)
(approv-ing the imposition of corporate income taxation on a Texas organization in which the capital was represented by transferable interests, the assets were vested in trustees having no authority to bind the individual beneficial owners, and which was apparently a part-nership under the laws of the state of Texas). Morrissey v. Commissioner, 296 U.S. 344 (1935), is regarded as having first articulated the test currently applicable in determining whether any particular organization is an association taxable as a corporation. See Treas. Reg. § 301.7701-2(a)(1) (as amended in 1983). Generally, the test is based on whether the arrangement provides the benefits typical of incorporation. See infra text accompany-ing notes 176-252 for a more detailed discussion of the corporate resemblance test.
20. See I.R.C. §§ 7701(a)(2), (3) (1986). The combination of these definitions is to treat any organization engaged in the conduct of a business for the purpose of generat-ing a joint profit as either a corporation or a partnership. See also Treas. Reg. §§ 301.7701-2 (as amended in 1983), 301.7701-4 (as amended in 1986). It is not clear precisely why limited partnerships escaped corporate taxation under early authorities. In
Eliot v. Freeman, 220 U.S. 178 (1911), the inclusion of associations in the definition of
corporations was held to contemplate any organization arising from statute or deriving a benefit from statute that did not exist at common law. This formulation would certainly seem to comprehend limited partnerships that are entirely a creature of statutory crea-tion unknown to the common law.
1980s the partnership form reached its zenith when a significant
number of partnerships had interests traded on the New York Stock
Exchange.22 While the utility of using the partnership form for pub-licly traded businesses was eliminated in 1987 by legislation impos-ing corporate taxation on most publicly traded organizations,23 efforts of nonpublic companies to find a means by which corporate benefits can be obtained without corporate taxation continue.24
II. THE CHOICE OF ENTITY DILEMMA
A. The Goal of Pass-Through Taxation
1. The Benefits of Pass-Through Taxation
The income of most businesses to which capital is a contributing factor would be subject to a lower tax burden by use of an entity
that permits income to be passed through to its owners rather than
to be subject to corporate income taxation.25 This assertion stems from the simple fact that the single level of tax on income earned through a partnership or an S corporation, imposed at the partner or shareholder level, should be lower than the double taxation imposed on income earned through a corporation.28 This conclusion is further supported by the fact that since 1986 the maximum rate of tax im-posed on the income of individuals has been lower than that imim-posed
the use of the limited partnership statutes." WARREN, supra note 17, at 306.
22. It is reported that the first publicly traded limited partnership appeared in 1981 and that there were between 100 and 125 such partnerships in existence by 1988.
See Willard B. Taylor, Master Limited Partnerships, 46 INST. ON FED. TAX'N § 28.01,
at 28-2 (1988).
23. Revenue Act of 1987, Pub. L. No. 100-203, § 10211, 101 Stat. 1330-403. This legislative change was in direct response to the fear that the growth of publicly traded limited partnerships would jeopardize the corporate tax base. See H.R. REP. No. 100-391, 100th Cong., 1st Sess. 1063 (1987).
24. A report to Congress of a joint study conducted by the Treasury and the Inter-nal Revenue Service (Service) with respect to the tax treatment of large partnerships did not recommend extending corporate taxation to such organizations. TREAs. DEP'T, WIDELY HELD PARTNERSHIPS: COMPLIANCE AND ADMINISTRATION ISSUES, REPORT SUB-MITTED TO CONGRESS (March 30, 1990), reprinted in [Mar.-Apr.] Daily Tax Rep.
(BNA) No. 64, at L-1 (Apr. 3, 1990). Recommendations have been made in the past to treat partnerships with more than a certain number of partners as corporations for tax
purposes. See, e.g., JOINT COMM. ON INT. REV. TAx., 95TH CONG., 2D SESS., SUMMARY OF
THE PRESIDENT'S 1978 TAX REDUCTION AND REFORM PROPOSALS 6 (1978). Apparently sentiments about large partnerships have changed. See H.R. 4287, 102d Cong., 2d Sess. 4301-05 (1992) (providing "simplified" rules for flow-through, audit, and compliance of partnerships with more than 250 partners or, at the election of the partnership, 100 partners).
25. This conclusion should not be applicable to a business in which the income is attributable to services simply because deductible salaries should be able to eliminate virtually all corporate taxable income.
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on the income of corporations.17
Thus, even before taking into
ac-count the impact of the second tax, the initial tax on business profits
will often be reduced under a pass-through tax regime. When the
impact of the second tax is added, even if the second tax is deferred
through accumulations of corporate income, the tax burden of
incor-poration increases.28
2. Exception for Income Splitting Situations
As with most other generalizations about taxation, there are
situa-tions in which the presumptive benefit of pass-through taxation will
not exist. One such exception may involve small businesses owned by
persons who are individually subject to the maximum tax rate. A tax
benefit could result from incorporation of such a business because of
the graduated tax rates imposed on the first $75,000 of corporate
income.29 Setting aside for the moment the impact of the second tax, business income passed through to the owners will be subject to a thirty-one percent maximum federal tax.30 With the graduated rates
imposed on the first $75,000 of corporate income, the corporate tax
liability will not exceed 31 % of taxable income until the income reaches approximately $210,000.31
Whether there is a significant tax savings possible from the use of
27. Compare I.R.C. § I with § 11 (1986). The imposition of a higher rate of tax on the income of corporations than on the income of individuals had not previously ex-isted at any time since the individual income tax was first imposed under the Sixteenth Amendment.
28. The second level of taxation on income earned through a corporation will be imposed when the shareholders realize the benefit of the income earned by the corpora-tion either in the form of dividends or as gain from the sale or other disposicorpora-tion of the stock.
Into the 1980s, the so-called General Utilities doctrine allowed the corporate level tax on the appreciation in the value of property to be avoided by the distribution of the asset in kind (see I.R.C. §§ 311(a), 333, 336 (1954)), or when the gain was realized by a sale incident to a 12-month plan of complete liquidation (see I.R.C. § 337 (1954)). See Gen-eral Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), which gave its name to the non-recognition rules even though the Court had refused to rule on the issue of corpo-rate gain recognition. The General Utilities doctrine, which had begun to erode years earlier, was finally eliminated by legislation in 1986. Tax Reform Act of 1986, Pub. L. No. 99-514, § 331, 100 Stat. 2085 (1986). The repeal of the General Utilities doctrine has removed all possibilities for avoiding the imposition of tax on corporate level gains. 29. See I.R.C. § 11(b) (1986). Such a situation is often created by splitting the income between the owners and the corporation.
30. I.R.C. § 1 (West 1992).
the progressive corporate rate structure by small businesses is some-what speculative. The eventual second tax must be balanced against the immediate tax savings possible under the graduated corporate rate structure. The current tax savings achieved by having access to graduated corporate tax rates on small amounts of income will have to exceed the present value of the deferred second tax. To illustrate, with income of $100,000, the tax on the corporation will be $22,250.2 Had the income passed through to individual owners tax-able at the maximum individual rate, the tax on the individual own-ers would have been $31,000.33 The use of the corporation thus produces an initial tax savings of $8,750. However, there also exists a deferred tax liability of at least $21,770.," The use of the corpora-tion is beneficial if this future tax liability is, in present value terms, less than the current $8,750 tax savings. Even at a ten percent per annum discount, the deferral would have to continue for nearly ten years to offset the effect of the second tax.5
In evaluating the benefit of utilizing the progressive corporate rate structure, it must be held in mind that unlimited accumulations of corporate income are not permitted under the Code. Rather, an on-erous surcharge is imposed on income accumulated in excess of the reasonable needs of the business.36 To avoid this surcharge, distribu-tions of excess funds must be made and such distribudistribu-tions will result in imposition of the second tax. Further, even where accumulations can be justified by the reasonable needs of the business, the business must typically be one that is expanding. With an expanding busi-ness, the income could quickly reach the level at which the effective corporate tax rate is not sufficiently less than the individual tax rate to justify the second tax regardless of the length of time the second tax may be deferred, and, at some point, the initial tax on business
income reaches slightly under $210,000. The combined rate of tax will reach 34% over-all at $335,000 of taxable income and the tax rate will thereafter be a flat 34%.
32. See I.R.C. § 11(b)(1) (West 1992).
33. See I.R.C. § 1 (West 1992). This illustration disregards the impact of state income taxation, which simplifies the illustration at the expense of ignoring some of the real economic significance of the choice.
34. The net after-tax income of the corporation is $77,750 and presumably in-creases the value of the corporation by a like amount. If this increase in value is recog-nized in the form of a long-term capital gain at the time the stock is sold, the federal income tax at 28% would be $21,770. If the income is distributed and taxed as a divi-dend, the applicable tax rate would be 31% and produce a larger deferred tax liability. 35. This comparison also fails to take into account the more restricted use of any excess funds necessitated by retention within the corporation and the double taxation imposed on the income derived from the use of the funds within the corporation during the period of the deferral.
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profits will become more onerous for having adopted the corporate form. The second tax, whenever incurred, will merely add to the cost of having incorporated.
It is often suggested that the double taxation of corporate income will be avoided by the retention of the stock until the death of the owner.37 At death, all property of the decedent, including stock, will pass to the heirs or legatees with a basis equal to fair market value and thus will permit the avoidance of the second tax by means of a sale of the shares or liquidation of the corporation.8
The fair market value basis arising on death of the shareholder will permit the deceased shareholder's successor to avoid the second tax on accumulated income through a sale of the stock, but it does not necessarily eliminate the tax cost of having incorporated. The date of death basis step-up will not avoid the double tax on future income if the business is continued. Further, if the business continues to operate and there is a desire to remove excess cash from the busi-ness through distributions, the date of death basis step-up will not efficiently eliminate the second tax because the stepped-up basis does not eliminate the corporate earnings and profits.39 Finally, incorpora-tion will significantly diminish the benefit of the stepped-up basis on death if the business has any built-in gain.40 The basis step-up ap-plies only to the stock, not to the basis of the corporate assets. The built-in gain in a corporation is subject to a potential double tax, and the basis step-up will eliminate only the shareholder level tax on the built-in gain. The other level of tax, the corporate tax, is not avoided.41
In contrast, the date of death basis step-up in the partnership con-text applies not only to the basis of the decedent's partnership inter-est, but may also result in an increase in the basis of the assets to the partnership.42 Thus, in a partnership, there is only a single level of
37. See WILLIAM S. McKEE ET AL., FEDERAL TAXATION OF PARTNERSHIPS AND
PARTNERS 2-8 (2d ed. 1990).
38. I.R.C. § 1014 (1986). With a fair-market-value basis in the stock, there should be no gain or loss realized on the disposition of the shares. See I.R.C. § 1001 (1986).
39. See I.R.C. §§ 301, 316(a) (1986).
40. "Built-in gain" refers to the excess of the value of an asset at any particular time over the adjusted basis of that asset. Obviously, built-in gain can arise either from changes in value or adjustments to basis.
41. Prior to 1986 the General Utilities doctrine provided numerous opportunities under the Code for corporations to avoid the recognition of gain on appreciated assets, and thus made the inability to step-up the basis of the assets in the hands of the corpora-tion less significant. All such provisions were eliminated in 1986. See supra note 28.
tax and that tax is eliminated by the stepped-up basis at death. 3
3. Public Trading Exception
With respect to publicly traded businesses, while pass-through taxation might still be preferable, it is not possible. The emergence of publicly traded limited partnerships in the early 1980s led to leg-islation in 1987 requiring all businesses with publicly traded interests to be taxed as corporations regardless of the form of organization
employed." It may also be true that any business desiring to become
publicly tiaded will find little merit in pass-through taxation during
the prepublic period.45
4. Identity of Investors Exceptions
The identity of investors may militate against pass-through taxa-tion. Specifically, tax-exempt and nonresident alien investors may desire to avoid investment in a pass-through entity that is engaging in an active business.
43. At one time it was thought that optional adjustments to the basis of partner-ship assets involved so much complexity as to make it an undesirable election. See
gener-ally McKEE ET AL., supra note 37, at 1 24.10[5] (stating that "continuing partners may
well decide that the benefits of the election ... [will be] more than outweighed by the potential long-term detriments to themselves, in the form of recordkeeping headaches and possible future basis decreases as to their interests"). The coming of the computer age hopefully has overcome most of the reluctance to make this election. Indeed, most of the publicly traded limited partnerships formed in the 1980s made the 754 election not-withstanding that the daily trading at differing prices made the administration of this election far more difficult than would be the case with a nonpublic company. See Taylor,
supra note 22, § 28.07, at 28-24.
44. I.R.C. § 7704 (1987). For a discussion of the limited exceptions to the imposi-tion of corporate taxaimposi-tion on publicly traded organizaimposi-tions, see McKEE, ET AL., supra note 37, at 3-85.
45. There is no necessity that businesses incorporate during their prepublic period. However, there is added complexity in explaining and in accounting for the prepublic period at the time of the public offering if a pass-through organization was employed. It is probable that businesses that desire to gain access to public markets would desire the simplicity of the corporate form. The tax consequences during a prepublic period are likely to be nominal in relation to the expected profitability that the prepublic sharehold-ers expect to realize from going public.
If a significant capital gains preference were to return to the tax law, the situation might change. The ability to have ordinary losses pass through to owners, which will be deductible against ordinary income not later than the year in which the interest in the company is disposed of (see I.R.C. § 469(g) (1992)), and which will be recovered as capital gains on the sale of stock, could produce significant tax benefits. This may be particularly attractive given that it may be difficult for net operating losses in early years to survive repeated financing under I.R.C. § 382 (1992). See Richard L. Parker, The
Innocent Civilians in the War Against NOL Trafficking, 9 VA. TAX REv. 625 (1990). Of
course, the presence of tax-exempt and non-resident investors who would typically not be in a position to use any losses passed through to owners might militate against such a plan.
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a. Tax-Exempt Investors
For tax-exempt investors, there will be a single level of tax
regard-less of whether the entity is a corporation or a partnership. If a
cor-poration is used, the corcor-poration will incur tax liability on all of its
income. However, the tax-exempt investor will be exempt from
taxa-tion when it realizes the benefit of its share of the income, regardless of whether realized in the form of dividends or gain from a sale or exchange of the stock.46 If the business had organized as a
partner-ship, there would be no entity level taxation, but the tax-exempt in-vestor would be treated as engaged in an unrelated trade or
business47 and would be taxed on its share of the business profits.48 While there could be some benefit from being subject to
pass-through taxation, either pass-through reduced taxation49 or increased cash flow,50 the potential benefits generally have not been viewed as sufficient to overcome the increased administrative burden entailed in reporting and paying tax on unrelated business income.51
46. I.R.C. § 501(a) (1986). 47. Treas. Reg. § 1.512(c)-I (1960). 48. I.R.C. §§ 501(b), 511-14 (1986).
49. The potential tax savings could arise from the ability of the taxexempt to use the progressive tax rates with respect to its share of income. See I.R.C. §§ 511 (a), 11 (b) (1986). This will obviously not be meaningful to sizable tax-exempt investors. An addi-tional tax savings is possible to the extent that the business, if incorporated, would accu-mulate income and generate passive income thereon in order to avoid the second tax that would otherwise be imposed on non-tax-exempt investors. When a corporation is used, the tax-exempt shareholder's share of the investment income attributable to the accumu-lation will be subject to the corporate-level tax. Similar investment income on accumula-tions in a partnership allocated to the tax-exempt investor would not be subject to tax as unrelated business income.
If there were numerous partnership investments in the tax-exempt organization's port-folio, some of which were producing losses, a tax savings would be possible from the ability of the losses from one organization to be used to offset the profits of another.
50. It seems evident that the use of the corporate form must result in greater accumulations than would otherwise be the case. If a business generates $100 of excess after-tax income, the shareholder will presumably desire to employ the funds in the most efficient manner possible. The choices are to leave the funds in the corporation, in which case the full $100 is available for investment, or to distribute the funds for individual investment. Because the distribution would result in a dividend and a tax of up to $31, only $69 would be left to invest. Obviously, the more efficient use of the funds is to retain them in the corporation. In effect, the benefit to the shareholder is an interest-free loan from the government conditioned on retention of the excess funds in the corporation. Given the incentive to accumulate income to defer the second tax, it must be reasoned that excess accumulations occur. See William S. McKee, Master Limited Partnerships, 45 INST. ON FED. TAX'N §§ 23.01, 23.03, at 23-9 (1987) (suggesting that this "lock-in effect" is one of the chief tax policy problems with the corporate income tax).
b. Nonresident Alien Investors
The situation of the nonresident alien investor is similar to that of the tax-exempt investor. For nonresident alien investors, their share of income earned through a corporation will be taxed at the corpo-rate level. In addition, the nonresident alien will be taxed a second time, through withholding, on that income when the benefit of that income is realized in the form of a dividend."' The United States generally does not impose a second level of tax on the nonresident alien when the benefit of the income is realized in the form of gains from the sale of the stock.53 Thus, double taxation may be at least partially avoided. However, the real economic impact of any United States tax is likely to be largely or entirely eliminated by the allow-ance of tax credits in the nonresident aliens country of residence.!4 In contrast to income earned through corporations, the active busi-ness income which a nonresident alien earns through a partnership is treated as income effectively connected with the conduct of a United States trade or business55 and is taxed to the nonresident alien in the same way such income would be taxed to any United States citizen or resident.56 The income earned by a nonresident alien through a partnership is not subject to a second tax when distributed.57 Again,
any United States tax should be creditable against tax due in the country of residence.58 Thus, there may be no economic impact to the nonresident alien from the choice of entity.
While the choice of entity may have little economic impact, a non-resident alien investing in an active business partnership will be re-quired to file a return and otherwise comply with United States tax law. This is an obligation which nonresident aliens understandably are not anxious to accept.
52. I.R.C. § 871(a)(1)(A) (1986). The tax imposed on dividends paid to a non-resident alien is 30% under the Code, id., but by treaty, it is widely reduced to as little as 5%. See, e.g., Convention Modifying the Convention for the Avoidance of Double Taxation, Dec. 30, 1965, U.S.-Neth., art. 5, 17 U.S.T. 896, 900-01 (reducing the tax rate on dividends to 5% for large shareholders and 15% for all others).
53. See I.R.C. § 871(a)(2) (1986). United States-sourced capital gains of nonresi-dent aliens which are not effectively connected to a United States trade or business are subject to United States taxation only if the nonresident is present in the United States for at least 183 days during the year in which the gains are realized. Id.
54. See, e.g., I.R.C. § 901 (1986) (allowing foreign tax credits in the United States).
55. I.R.C. § 875(1) (1986). 56. I.R.C. § 871(b) (1986).
57. But see I.R.C. § 897 (1986) (effectively treating a foreign corporation's share of income from a United States partnership as income from a United States branch operation and imposing a so-called dividend equivalent tax on such profits).
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c. Potential Benefits of the Corporate Tax Regime
In addition to the fundamental difference between the double
tax-ation of corporate income and the pass-through taxtax-ation of
partner-ship income, there are other significant differences in the tax
regimes.59 One disadvantage of the partnership form often presented is that partnerships may not be acquired in a tax-free
reorganiza-tion.0 It is unquestionably true that partnerships may not be
ac-quired in a tax-free reorganization,6' but it is less clear that this is a
significant disadvantage. Partnerships are subject to only a single
level of tax, and that tax generally cannot be deferred by means of a
59. For a nonjudgmental and relatively complete topic by topic comparison of the tax rules governing corporations and partnerships, see Elliot Tannenbaum, The Business
Entity: C Corp. v. S Corp. v. Partnership, 45 INST. ON FED. TAX'N § 6.01 (1987). 60. I.R.C. § 368(a) (West 1992) defines a reorganization as a transaction involv-ing corporations. The partnership and the partners can engage in reorganization-like transactions only if they qualify for nonrecognition under I.R.C' § 351. See infra note 61. S corporations can be acquired in a tax-free reorganization. See I.R.C. § 1371(a) (1986).
The ability to engage in a tax-free transaction is most significant when the only consid-eration available is the purchaser's stock and that stock cannot be readily converted into cash, at least to the extent necessary to meet any current tax liability. This is usually the case when the purchaser is not a publicly traded corporation. On the other hand, if the purchaser had adopted a form that qualified as a partnership for tax purposes (see infra text accompanying notes 312-98), any acquisition could be structured to defer gain under I.R.C. § 721 without the burden of qualifying under the baroque rules of I.R.C. § 368. It is possible that this section of this Article could have been organized as a discussion of the ease of acquistions by partnerships rather than as a discussion of the difficulty part-nerships have in being acquired by corporations.
tax-free reorganization. Thus, whatever gain exists in the partnership must be recognized at the time of the disposition of the partnership. On the other hand, income previously earned will already have been taxed completely and will not, whether or not it has been distributed, result in any additional tax burden when the business is sold.
When corporations are reorganized, shareholder gain or loss is not recognized to the extent that the consideration received is stock of the acquiring corporation. 2 The tax burden on the built-in gain is not forgiven; it is deferred. The shareholder-level gain is transferred to the stock received through an exchanged basis and thus will be subject to tax when disposition of that stock occurs.63 It is this abil-ity to defer the owner-level tax which makes a reorganization beneficial.
While reorganizations permit deferral of gain, it should be remembered that the gain deferred will include gain attributable to both accumulated income and to built-in gain. In addition to the shareholder level deferred gain, there will also be deferred corporate level tax on the built-in gains.64 The acquired corporation or its suc-cessor in the acquisition will continue to hold the assets at their pre-acquisition basis. It will therefore recognize any built-in gain and incur a tax liability at the corporate level either upon the disposition of those assets or through their use in the business. It will do so without depreciation allowances which reflect their economic cost in the acquisition. Because the purchaser is assuming the tax liability associated with low basis assets, it must, at least in theory, reduce the purchase price it is willing to pay in order to reflect this assumed liability in the same way it would reduce the purchase price for any other liabilities assumed.65
In light of the above, whether the ability to engage in reorganiza-tion transacreorganiza-tions is a benefit militating in favor of the corporate form depends upon whether the immediate single level tax imposed on the built-in gain in a partnership will be greater than the sum of (1) the present value of the deferred double taxation on the built-in gain of the corporation, (2) the deferred shareholder-level tax on accumu-lated income, and (3) the double tax cost already incurred on income previously earned and distributed. In view of this balancing, it may be more accurate to consider the reorganization provisions as a
62. I.R.C. §§ 354, 356 (1986). 63. I.R.C. § 358(a)(1) (1986).
64. Corporate-level gain is deferred but is not eliminated through a tax-free reor-ganization. See I.R.C. §§ 361, 362(b) (1986).
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means by which to ameliorate the more onerous tax burden other-wise associated with the corporate form than to characterize the ability to participate in a reorganization transaction as a benefit of the corporate form.
Depending upon whether the corporate or a pass-through form is adopted, there is some difference in the ability to provide nontaxable fringe benefits to active owners. But most of the significant dispari-ties have been eliminated by the equalization of treatment of quali-fied plans.66 Only a limited number of differences remain, and these differences are generally not very substantial.67
d. Other Differences
Further differences between corporations and partnerships for tax purposes involve the taxation of admissions of new members in ex-change for contributions of appreciated property,68 the taxation of redemptions, 9 and the taxation of distributions inkind.70 In each
case, the partnership regime permits rearrangements of the business relationship without significant tax liability at the time of the trans-action, whereas a similar transaction in the corporate context would result in recognition of gain.7'
e. Summary
In summary, there are situations in which corporate taxation may be either necessary or desirable. However, in the absence of such situations, businesses will find that avoidance of corporate income taxation will result in a significant tax savings. 2
B. Preference for Incorporation for Business Purposes
The principal reasons that businesses will generally prefer to in-corporate for non-tax purposes are that the in-corporate form provides
66. See generally Jerome E. Harris, Parity in Employee Benefit Plans and Fringe
Benefits for the Self-Employed after TEFRA and TRA '84, 62 TAXES 529 (1984).
67. See generally, McKEE ET AL., supra note 37, at 2-16 to 2-18. 68. Compare I.R.C. § 351 with I.R.C. § 721.
69. Compare I.R.C. § 302 and § 311 with I.R.C. § 731. 70. Compare I.R.C. § 301 and § 311 with I.R.C. § 731. 71. See generally Tannenbaum, supra note 59.
statutory protection to the owners against personal liability for the obligations of the business3 and that a corporation has a potentially perpetual existence.4 In contrast, the partnership form, at least in theory, requires that one or more owners have personal liability for the obligations of the business5 and that changes in the ownership of the partnership will cause its dissolution."'
1. Owner Liability
That owners of a business prefer to avoid personal liability is obvi-ous. Of course, there are situations in which countervailing consider-ations, including tax considerconsider-ations, could be of overriding significance. When countervailing considerations exist, a decision not to incorporate may be further justified by the fact that the unlimited liability of partners and the limited liability provided shareholders are not absolute. Most obviously, partnerships may be formed in which limited partners do not have any personal liability unless they participate in the management and control of the business.77 Of course every limited partnership must have at least one general part-ner who will have unlimited personal liability.7 8
The practical exposure of general partners to liability can be ame-liorated in several ways. With respect to tort and certain other kinds of liability, the general partner's practical risk can be greatly re-duced through appropriate insurance. The general partner's risk for contractual liabilities can be avoided simply by obtaining the agree-ment of the creditor to limit its recourse to the assets of the partner-ship. Indeed, if a creditor would be willing to extend credit to a comparably capitalized corporation without guarantees from share-holders, they should be as willing to extend credit to a partnership with recourse limited to partnership assets. In addition, the personal liability of the ultimate individual owners can often be avoided through the use of a corporation to act as general partner.79
Just as partners need not necessarily discharge all partnership ob-ligations personally, the corporate form does not necessarily protect
73. REVISED MODEL BUSINESS CORP. ACT (MODEL CORPORATION AT) § 6.22
(1984).
74. MODEL CORPORATION ACT § 14.02.
75. UNIFORM PARTNERSHIP AT (UPA) § 15 (1914); REVISED UNIFORM LIMITED PARTNERSHIP AcT (RULPA) § 403(b) (1976) (amended 1985). Unless otherwise indi-cated, references to the RULPA are to the act as amended in 1985. When necessary to distinguish between the RULPA before and after the 1985 amendments, the pre-1985 RULPA is referred to as RULPA (1976) and the RULPA with the 1985 amendments as RULPA (1985).
76. UPA §§ 29, 30; RULPA § 801.
77. RULPA § 303. See infra text accompanying notes 272-86. 78. RULPA §§ 101(7), 403(b).
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the shareholders in all events. Creditors will often extend credit to a corporation only with guarantees from shareholders. Further, the corporation will be an effective shield against liability only if the creditor is not permitted to "pierce the corporate veil""0 or to pro-ceed against the shareholder under theories sounding in agency, fraud, or estoppel."'
That partners may take steps to ameliorate their personal risk and that shareholders may be required to answer for the obligations of the corporation in some circumstances does not alter the facts that personal liability is often the paramount concern of persons investing or participating in a business and that the most direct protection against personal liability has been incorporation.
2. Organizational Continuity
The potentially perpetual existence of a corporation is also a sig-nificant consideration which favors the corporate form, at least when the organization has significant capital. It would simply be unaccept-able if any owner could force the winding up of the business or, al-ternatively, demand redemption at any time. If a corporation is used, shareholders have no right to withdraw and thus cannot unilaterally cause the winding up of the corporation or withdraw and demand redemption. In the partnership context, general partners have the right to withdraw at any time unless there is a contrary agreement, 2 and any withdrawal by a general partner will at least potentially cause the dissolution of the organization and lead to the winding up of the partnership.3 Even with a contrary agreement, the general partners retain the power, though not the right, to withdraw. 4 A general partner exercising the power to withdraw in contravention of the agreement will have to respond for damages, if any. Neverthe-less, such partner will have the right to a distribution subject to the
80. See generally Cathy S. Krendl & James R. Krendl, Piercing the Corporate
Veil: Focusing the Inquiry, 55 DEm'v. U. L. REV. 1 (1978) (endeavoring to identify the
standards and the variations in the standards used to find shareholder liability). 81. For a discussion of the various theories for finding shareholder liability which are not based on piercing the corporate veil, see Krendl & Krendl, supra note 80, at 2.
See also Note, Liability of a Corporation for Acts of a Subsidiary or Affiliate, 71
HARV. L. REV. 1122, 1123-25 (1958).
82. UPA § 31(1)(b); RULPA § 602.
83. See UPA § 31 (dissolution results on any withdrawal of a partner from a gen-eral partnership); RULPA § 801(4) (dissolution results on the withdrawal of a gengen-eral partner unless a remaining or new general partner continues the business in accordance with the partnership agreement).
agreement of the partners and to offset it by any damages.85 While something approaching corporate-like continuity of life can be ac-complished by agreement, continued existence is of great importance and is most clearly and simply achieved through adoption of the cor-porate form.
3. Other Business Considerations
Other fundamental differences between the corporate and partner-ship form include disparate rules regarding management,8" transfer-ability of interests,87 and organizational flexibility.88 While it can be generally stated that limited liability and organizational continuity will militate in favor of incorporation in most businesses, generaliza-tion as to the impact of these addigeneraliza-tional considerageneraliza-tions is not
possi-ble. Whether centralized, representational management or the ability
to transfer interests are desirable will depend on the needs of the specific business. When such characteristics are desirable, the prefer-ence for incorporation should be strengthened because these attrib-utes are typical of corporations. On the other hand, even if the owners desire a more flexible management structure and restrictions on transferability, attributes typical of partnerships, these facts alone should seldom lead a business to avoid incorporation.
While free transferability of corporate shares will exist in the ab-sence of a contrary agreement, all that is necessary to restrict trans-ferability is an agreement between the shareholders.8 Any such
85. See UPA § 38(2); RULPA § 604.
86. General corporation laws vest management in a board of directors elected by the shareholders. See MODEL CORPORATION AcT § 8.01(b). But see MODEL CORPORA-TION ACT § 8.01(c) (permitting corporations 'with fewer than 50 shareholders to estab-lish a management structure that does not involve a board of directors); MD. CODE ANN.,
CORPS. & ASs'Ns §§ 4-302, 4-303 (1989 & Supp. 1991) (permitting a flexible manage-ment structure in a so-called close corporation). In contrast, partnerships are directly owner managed by the general partners unless the partners have agreed to the contrary.
See UPA §§ 18(e), (h); RULPA § 403(a).
87. Compare MODEL CORPORATIONS ACT § 6.27 (providing that shares of stock
are, in general, freely transferable) with UPA § 27 and RULPA § 702 (generally pro-viding that partners may not assign their rights as a partner and cause the assignee to be substituted in their place).
88. The relationship between partners is fundamentally contractual. Thus, while the UPA provides the terms of the contract, which will be controlling in lieu of a con-trary agreement, the partnership acts expressly recognize the right of the partners to agree otherwise. Thus, for example, management can be vested equally in all partners or restricted to one person, whether or not a member and profits, losses, and distributions can be made per capita, in proportion to contributions, or in any other manner the human mind can conceive. See UPA § 18. The corporate form is more rigid. Generally, absent the applicability of a unique state law statute or qualification as a close corpora-tion, management is necessarily vested in a board of directors. Voting rights and eco-nomic rights are held in proportion to the ownership of shares and any desire to have varying rights must be accomplished by the creation of a different class or series of shares.
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agreement can be enforced against purchasers simply by disclosing
the existence of any restrictive agreement by a legend on the share
certificates.90 A flexible management structure may be more difficult
to create in a corporation,91 but the constraints on the management
form by themselves will seldom be sufficient to lead the owners to
forego limited liability or organizational continuity.92
An additional factor which may, at least in the past, have strongly
militated in favor of incorporation has been the fact that corporate
law is better developed, more certain, and generally more familiar to
investors and the bar alike.9" How significant any such ,disparity
re-ally has been, and whether it will continue, are entirely speculative.94 It also seems reasonable to suggest that most uncertainty or unfamil-iarity with the partnership form arises from the different ways in
which the two organizations have been used. To the extent that one
considers the tax-shelter partnerships of the 1970s and 1980s as the prototype of the business partnership, the conclusion suggested is ap-prorpriate. These partnerships were enormously complex with tier upon tier of allocation and distribution provisions and innumerable
special provisions that served no apparent function other than to
cope with various tax concepts.95 When the partnership will simply provide for all distributions and allocations to be made pro rata to
§ 6.27(c) (requiring a reasonable purpose for restricting transferability). 90. MODEL CORPORATION AcT § 6.27(b).
91. But see supra note 88.
92. Another difference may arise under the securities laws. While corporate stock will always be a security, non-stock interests may not be. See generally Mark A. Sar-gent, Are Limited Liability Company Interests Securities?, 19 PEPP. L. REV. 1069
(1992).
93. This may, of course, be due in large part to the fact that partnerships are simply more flexible. There is little to understand except that the desired relationship must be created by agreement rather than imposed by statute.
94. See MCKEE ET AL., supra note 37, at 2-12, suggesting that, to the extent this difference existed, it has likely narrowed significantly with the widespread adoption of the RULPA and the acceptance of the limited partnership form for public companies, in leveraged buy-outs and other business transactions.
the ownership of units, as would be the case with simple corpora-tions, it seems unlikely that many would object that the arrangement is unfamiliar or uncertain.
4. Summary
In summary, if tax considerations are disregarded, the protection against liability and the presence of organizational continuity af-forded by the corporate form would lead most businesses to incorporate.
C. The Dilemma
It is difficult to generalize regarding the proper organizational form for a new business. There are simply too many variables that will result in significant exceptions to any statement of purportedly general application. However, with the caveat that there will be sig-nificant exceptions, the above discussion points to a common di-lemma faced by many new businesses: the desire to avoid incorporation for tax purposes versus the desire to incorporate for non-tax, business purposes.
Where this common choice of entity dilemma exists, the problem is how it can or should be resolved. Three basic options are available: 1) incorporate and elect to be subject to the pass-through taxation provided in subchapter S of the Code,98 2) incorporate and take steps to ameliorate the increased tax burden,9 7 and 3) avoid
incorpo-ration and endeavor to address the business issues by other means.9 8
III. THE S CORPORATION SOLUTION TO THE DILEMMA
Incorporation and election to be taxed on a pass-through basis under subchapter S may appear as the obvious and best solution to the choice of entity dilemma. For those who qualify, it is probably the solution most often chosen. However, not all businesses can qual-ify to make the election under subchapter S, and not all businesses that qualify should adopt this solution.
A. Limited Availability of the S Election
To qualify for the subchapter S election, the corporation may not have more than thirty-five shareholders,9 have any shareholders who
96. See I.R.C. §§ 1361-78 (1992). See infra text accompanying notes 104-67. 97. See infra text accompanying notes 168-74.
98. It is this alternative that has expanded substantially in recent years and that has the potential to finally solve the choice of entity dilemma. See infra text accompany-ing notes 176-398.
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are not United States citizens or resident individuals,10 0 have more
than one class of stock, 01 or be a member of an affiliated group.10 2
These limitations can make the S election impracticable for many
businesses.
The subchapter S election is particularly problematic when one of the owners desires to have some preference to the earnings or assets of the business, while the business cannot realistically take on the
burden of annual interest payments or the obligation to repay loans at a certain time in the future. In any such case, the prohibition
against two classes of stock will make the S election
impracticable.0 3
To a new business seeking capital, the prohibition against having shareholders who are not United States individuals is probably the most debilitating. A new business in need of capital can ill-afford to shut itself off from investments by tax-exempt entities, nonresidents, partnerships, corporations, or other nonindividual sources.
100. I.R.C. § 1361(b)(1)(A), (C)(1992). 101. I.R.C. § 1361(b)(1)(D) (1992).
102. I.R.C. § 1361(b)(2) (1992).
103. The desire for preferences may arise simply from the differing investment desires of the investors, but will arise in other ways as well. The need for a preferential class of stock can also arise when the corporation desires to issue shares to a service provider to whom the parties wish to provide only a share of the future income and growth in value. This may be a particular concern in that a shift of capital could result in a prohibitive tax being imposed on the service provider. See I.R.C. § 83 (1992); St. John v. United States, 84-1 U.S. Tax Cas. (CCH) 9158 (C.D. Ill. Nov. 16, 1983). In order to avoid the transfer of a current capital interest, the capital of the business must be secured to the non-service providers. This is possible only through the creation of prefer-ences. In an S corporation, the prohibition against the use of a second class of stock necessitates that the preference be established in the form of an indebtedness. This in-debtedness must in turn be sufficiently reflective of an arm's length transaction to avoid characterization as an equity interest violating the prohibition against S corporations is-suing more than one class of stock. It can prove extremely difficult to achieve both the tax and business objectives in this context.
